Capture more business using Porter
Developed by Michael Porter in his 1985 best-seller, Competitive Advantage: Creating and Sustaining Superior Performance.1 the value chain may seem like something that is purely theory or only relates to larger businesses. However the work that Porter did can be just as useful for SMEs looking to expand their company.
Porter suggested that any business is split into two primary parts; margin earning primary activities and secondary support activities. But we can extend this to the whole process of producing an item, working on it, getting it to the end user, selling it and commissioning it for use. The trick for firms looking to increase their profitability is to capture more of the primary work of the value chain and reduce the impact of the support activities.
By using Porters’ work, not at the micro level of a single firms’ activity but at the macro level of the whole process of a sale chain and seeing this as an economic ecosystem the business owner can find methods of increasing sales and profitability.
So how can a smaller business capture more of a value chain? Let’s use an example of an engineer who refurbishes broken second hand starter motors for cars (the figures are examples only). The engineer buys the starter motor for £10 from a car breakers yard, works on them and sells them for £20 to a local mechanic. The mechanic then sells them to the customer for £30 and charges £10 to fit the unit. For the sake of this example let’s imagine that the breakers yard estimates that the cost to them of the individual starter motor from each car is £2. The total value in this chain is £38.
How can the engineer capture more of this value?
Taking it logically let us start at the beginning. The Engineer pays £10 for a second hand unit to the breakers. There appears to be two options here; the first is to buy second hand cars and break them himself. With his skills there are more items in the broken car that can be refurbished such as the alternator, and sold on for a profit with the rest either sold to the scrap yard or to retail buyers. The second way he can capture more of this part of the chain is to offer a small discount to the mechanic if they bring back the old, unserviceable unit that they replace.
When the engineer refurbishes the units there is naturally a cost. The part of the value chain that is in the immediate control of our engineer in our example is this work. The engineer can increase the margin the he eventually retains by making efficiencies in the work done and the purchasing of any goods used to refurbish the motor.
The engineer sells his units to trade buyers who then sell these on to retail customers. One of the ways that our engineer can capture this section of the value chain is to sell direct (and at a higher price) to his own retail customers. Although it may seem that the sale has come through the additional fitting service of the mechanic, in fact there are significant other markets such as the DIY buyer who would value being able to purchase directly.
The final section of our ‘macro value chain’ is the service part. The engineer has now already captured part of the chain by selling directly to retail customers and it would be a small step to then offer his own fitting service to customers thus obtaining the final section.
The theory sounds fine, but naturally there will be obstacles. There will be costs both in terms of initial investment and direct costs which means that in practice it is unlikely that the engineer will be able to capture the whole £38 in its entirety. It may also be that by trying to do everything, the business person takes their eye off their core activity which is actually refurbishing starter motors. The fashionable practice of outsourcing non-core activities is a response to this issue.
There are a number of other secondary support activities that also sap margin which means that whilst the engineer in our example makes more margin, this is being eaten away by increased or inefficient HR or technology for instance. Outsourcing inefficient support activities can help the business concentrate on capturing the value creating activities in the supply chain.
Whilst it is clear there are issues with this approach, we can see that for smaller businesses taking Michael Porters’ academic theory, moving it into the macro view of the firm and applying it to real life situations it is possible to increase margin and find additional markets for our business. The key for the effective manager is to take our simple example, transfer that to their own business and then assess and adopt those parts of the process that will provide the greatest benefit.
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Reference 1 Porter, Michael E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance. New York, Simon and Schuster